Capital Asset Pricing Model

Capital Asset Pricing Model which is based on the

Capital Market Theory deals with how a risky asset
is priced in competitive or Efficient Capital Market.
Capital Market theory is extension of portfolio theory
of Markowitz. It was the existence of risk free asset
which leads the development of modern capital
market theory. Capital Asset Pricing Model helps
investors to determine the required rate of return of
a risky asset. An efficient capital market provides
investors increasing return for increasing risk.
 Assumptions
 Investors make investment decisions solely on risk and return
assessment.

 The purchase or sale of a security can be under taken in infinitely

divisible units.

 Investors can borrow or lend any amount of money at risk free rate of
return.

 The purchase and sale by one investor can not affect the price of the
security.

 All investors have homogeneous expectations, i.e., they estimate

identical probability distributions for future rates of return.

 There is no tax or transaction cost in buying or selling assets.

 Investors can short selling any amount of shares without any limit.
 Expected Return of a Risky Security-

E ( Rit ) = α i + β i X t
If alpha is 2, beta is 1.5 and Sensex is expected to give 2 percent
return, then the expected return of the stock will be-
E(R)=2+1.5*2
=5%
 Expected Return of Portfolio-

R p = wi E ( Rit )
 Required Rate of Return of a Risky
Security-
The required rate of return of a risky asset is that return
which investors expect or he should get by holding this
risky asset.
Ri = R f + βi [ E ( Ri ) − R f ]

If risk free return is 5%, return on risky security is 6%, beta

value of the same security is 1.20, the required return
will be.

=5+1.2 [6-5] or 6.2 %

 Portfolio Return when portfolio includes
both risky and risk free assets
Portfolio Return is the aggregate of weighted average return
of risky securities and risk free securities in the portfolio.

E ( R p ) = wR m + (1 − w) R f

If w =1, total fund is invested in risky portfolio.

If w <1, Partial amount of total fund is invested in risky
portfolio and partial amount of fund is invested in risk free
portfolio.
If w > 1, Investors is borrowing at the risk free rate and
investing in his portfolio.
 TB’s
(70 m)

Income Portfolio
(100 m)
Govt. Bonds
(30 m)

Balance Fund
(200 m) Reliance En.
(20 m)
ABB
(20 m)

Growth Portfolio
(100 m)
ONGC
(10 m)
TISCO
(50 m)
 Risk of Individual Risky Securities-
Total Risk = systematic Risk (Market Risk) + Unsystematic
Risk (Non Market Risk)

σ =β σ
i
2
i
2 2
Xt +e 2
it

 Portfolio Risk
Portfolio risk is the aggregate weighted average risk of
individual security in the portfolio.
 N
   N
2 2
σ p =  ∑ ( wi βi ) σ X  + ∑ wi ei 
2 2 2

 i =1   i =1 
 Portfolio Market Risk
Portfolio Market Risk is the aggregate of weighted average
market risk of individual security in the portfolio.
N
βp =∑wi βi
i=1

A high beta value portfolio is considered high risky portfolio

since the return of this portfolio is highly integrated with the
return of market. Beta which is measurement of market risk
of portfolio can be calculated by regressing the return of a
security with the return of some index. Symbolically it can be
written as
n∑ XR − ∑ X ∑ R
βi =
n∑ X − ( ∑ X )
2 2
 Capital Market Line
A capital market line indicates the trade off between
investors’ portfolio risk and portfolio return. Investors
would be ready to take extra risk only when they will
expect extra return.
 Security Market Line
A Security Market Line exhibits the various combination of
portfolio market risk and portfolio return. In an efficient
capital market, investors want increasing return for
increasing risk. They will be ready to bear extra market risk
only when they will extra risk premium. SML facilitates the
investors to determine the required rate of return for given
level of market risk.
Arbitrage Pricing Theory
Arbitrage Pricing Theory was developed by Stephen Ross in 1976. APT
outlines that several systematic factors affect a security return. It
recognizes the impact of several systematic factors separately. These
factors are inflation, industrial production, movement in the interest
rate.

E ( R) = α + β 1 X 1 + β 2 X 2 + β 3 X 3 + .....β i X i + e
E ( R) = α + β ik fik + e
• Expected Return on Risky Security
• α Required return
• βik Security Sensitivity to change in the systematic
factors.
• fik Return on systematic factors.
• e Unsystematic factor associated to the security.